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Passive Investing: The Choice of More Investors

Passive generally refers to investing in index mutual funds or exchange traded funds rather than active managed mutual funds.  The rivalry between the approaches has raged for years, but evidence is mounting for passive funds.  And investors are listening.

In 1999, $12 billion of exchange traded funds (ETFs) were issued.  Net issuance of ETF shares rose to $177 billion in 2008.  From year end 1998 through 2008 ETFs issued $661 billion in new shares.   The rise in demand came from both institutional and individual investors, according to the Investment Company Fact Book. (www.ici.org

Why the passive approach?

Passive investment vehicles include index mutual funds and exchange traded funds (ETFs).  Both track the performance of a basket of securities included in an index.

For instance, the Russell 3000 Index measures the performance of the broad U.S. equity market.  The Ishares Russell 3000 Fund (IWV) is an exchange traded fund that holds a representative sampling of the securities in the Russell 3000 index.  The sample has an investment profile similar to the index, and may or may not include all of the securities that are included in the index.

As of 10/31/2009 the Russell 3000 index included 2,968 securities.  The Russell 3000 Fund (IWV) held 2,964 of the securities included in the Russell 3000 index. (source:Morningstar)

An index does not invest in the securities, it simply tracks their performance.  Therefore there are no fees included in the index returns. 

Funds, however, invest in the securities and the performance is reduced by transaction costs and other ongoing costs, such as management fees and other fund expenses. The net annual expenses, ongoing costs, for the Russell 3000 Fund are .20% (1/5 of 1%), according to the 2009 annual report.

A fundamental reason investors choose a passive approach is because they are aware that the majority of actively managed mutual funds are not able to out perform their benchmark index over an extended period of time.  The high expenses associated with active management such as transaction and ongoing costs,  reduces the fund’s performance by an average of about 1.5% per year, according to http://www.icifactbook.org/fb_sec5.html

That means if the index posts an 8% return, the average active managed fund would have to achieve a 9.5% return in order to net 8% after costs. If the fund’s returns are less than 9.5%,  it under performs the index. 

Relatively efficient pricing of stocks and bonds along with costs associated with active management makes beating the index a daunting task.  According to a Standard and Poors study, Indices Versus Active Funds Scorecard, Year End 2008, less than 50% of active managers beat their indices over a 5-year period.

An analysis of two – five-year periods of performance; 2004 to 2008 and 1999 to 2003 revealed the following for…

…Large-Cap Active Managed Funds: 72% under performed their S&P 500 index in 2003 to 2008 period, 53 % under performed in 1999 to 2003. 

…Mid-Cap Active Managed Funds: 79% under performed the S&P MidCap 400 benchmark in 2004 to 2008 period, and 91% under performed in 1999 to 2003.

…Small-Cap Active Managed Funds: 86% under performed the S&P SmallCap 600 benchmark in the 2004 to 2008 period, 69% under performed in 1999 to 2003.

According to the study, one consistent investment myth has been that active managers have an advantage in bear markets due to the ability to move quickly into cash or defensive securities.  The study analyzed the performance of active managers during the past two bear markets, 2008 and 2000-2002.   The report illustrated over 50% of the active Large-Cap funds under performed their benchmark, over 70% of the Mid-Cap and Small-Cap funds under performed their respective indices. 

The under performance of active managed international equities and bond funds were similar to U.S.  stock funds. 

To view this study you may have to copy and paste this url  http://www2.standardandpoors.com/spf/pdf/index/SPIVA_Rerpot_Year-End_2008 

In conclusion

Exchange Traded Funds and Index Funds offer low cost ownership of both stocks and bonds.  The high cost of active management is one stumbling block that is difficult to overcome for most active managed funds.  Even in bear markets, the majority of active managers fail to beat their benchmark index.

Golden Hills Financial Group is an independent investment advisory firm utilizing exchange traded funds and index funds in portfolio construction.

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